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Business owners, experts at managing their own business, are often at a loss when it comes to understanding how potential lenders make decisions about whether or not to extend credit to a business. Owners often picture a process as simple as a formula that takes their credit score or revenue numbers and spits out a “yes" or “no." Other owners have shared with me the view that granting credit is completely arbitrary, having more to do with what some remote, anonymous underwriter had for breakfast that day than anything to do with the merits of the business or the deal.
Understanding your underwriter’s tools of the trade is essential for business owners and their advisory team in order to make their companies as attractive as possible to lenders. At the most basic level, these tools are encapsulated in the “5 Cs of credit."
“Character" refers to the personal integrity of a business’ owners and officers. In simpler times, character could be judged by personal knowledge of the borrower by a community banker who may have known the borrower and their business for years. Today, personal relationships of that kind are much more rare and, in any case, federal regulations do not allow banks to rely solely on such informal criteria. Instead character is judged by proxy, that is, by objective indicators of personal integrity.
Examples of proxy indicators include personal and business credit scores, which demonstrate to some extent the ability and willingness of owners and officers to meet their current and past obligations. Very important too is the completeness, accuracy and candor employed in providing required documentation to the lender.
Because these things are only proxies, lenders know that they are imperfect indicators of character. A poor credit score may have a good explanation that has nothing to do with a borrower’s character. Thus it is critical that business owners and their advisors identify potential character red flags in advance and address them head-on with the lender. You can potentially turn a bad mark into something that demonstrates good character rather than the reverse.
“Capacity" refers a business’ ability to repay a proposed new debt through cash flow from ordinary business operations. Banks consider their loans as investments in their clients’ businesses. It is no wonder that banks are rarely interested in loaning money to a business that is losing money, just to keep it afloat awhile longer until it fails or becomes profitable [note: businesses that are losing money but have growth potential may be interesting to other types of investors like venture capitalists]. Rather, banks invest in businesses where their investment has the potential to help a successful business grow or improve in some way. A new piece of equipment might improve the gross margin by making manufacturing less expensive. An acquisition of another company may open up new markets and increase gross revenue.
To demonstrate capacity, you must provide the bank with financial statements demonstrating historical cash flows. The underwriter will identify cash available to service the proposed debt and calculate a ratio called “debt service coverage," (dollars available : dollars needed for debt). A 1:1 ratio indicates that for every dollar you need to service your debt, you have one dollar available through the business’ revenue. Most banks would like to see ratios between 1.15:1 and 1.50:1.
Borrowers can improve the analysis by offering two additional pieces of information. First, a borrower should offer financial projections. The ability to provide projections demonstrates both that the borrower has put the time, thought and expertise into the running of their business to prepare annual budgets and take steps to meet them and that the borrower expects the business to continue to generate revenues in the near term. If the projections indicate increased revenue over the historical financials, and there is a sound basis for the expected increase, the bank probably will not rely on the projection alone but it will help to give the bank greater comfort if other factors appear more tenuous.
Secondly a borrower, with the help of their advisory team, should give an account of specifically how the new credit extension will help the business to grow or otherwise improve. Banks invest in clients’ businesses specifically for this reason. Internally, they will attempt to make this argument to themselves before extending credit. However, as with any business, banks have employees whose skills and experience vary. Why leave it up to even the best bank employee to figure out how a particular loan will improve your business when you are the expert? Don’t leave the matter to chance! Be explicit and tell your banker exactly how your company will grow or improve with the proposed loan or line of credit. Help the banker understand why an investment in your company is a good one.
“Capital" refers to the net worth, or equity, of your business. The balance sheet definition of net worth is assets minus liabilities. In the context of the 5 Cs of credit, a lender will infer a number of implications from that simple equation.
For example, a business with greater capital is generally better able to weather financial strains, such as cyclicality, downturns in the economy at large, catastrophic or unforeseen events, and so forth. A better capitalized business is better able to draw on its own resources if necessary to meet its obligations even when revenue from sales falls short for a period of time.
Equity also represents the stake that business owners have in their business. Owners with a greater personal stake in the business are thought to be more likely to do all they can to keep the business running and profitable and less likely to make business decisions that are too risky.
While it is okay, and expected, that businesses will leverage their capital, lenders will expect the debt to equity ratio to be limited. What that limit is has a lot to do with what is common in the particular business’ industry, however a 3:1 ratio is a reasonable rule of thumb.
Finally, net worth tells the lender about how the owners and officers manage the business. Are they taking all of the money out of the business in the form of salaries and distributions? Or are they leaving revenue in the business as retained earnings to help increase the business’ capital? There can be good reasons, including tax reasons, for doing either. The important thing is that the business owners or officers have a good reason that they can articulate to the lender. Inability to satisfactorily explain why revenues are always completely paid out, for example, can become a “character" issue in the sense that it reflects on the owners’ management acumen.
“Collateral" refers to the assets that will be used to secure the debt. Borrowers frequently believe that this is the most important “C" of the 5, but if they are looking to borrow from a bank they are wrong. Collateral is an important precondition to many loans, but banks are not in the business of reclaiming and reselling assets. When a bank has to repossess an asset that was used as collateral, it nearly always loses (i.e. fails to recoup money lent after time and costs involved). At best, the bank breaks even.
That is why banks like to have two and sometimes three sources of repayment available prior to having to foreclose on collateral. The first source of repayment is always from ordinary operation of the business. Second and third sources of repayment can be from individual business owners or from liquid or liquidate-able business assets.
The bottom line is, the more you can prove to the bank that a loan can be repaid short of collection of collateral, the more likely you are to get the loan you want at the best possible terms. Conversely, if you go to the bank wanting to borrow against a piece of collateral and argue with them that the collateral should be enough, you probably won’t get the terms you want and you may not get the loan.
“Conditions" refers both to the state of the borrower and the state of the industry or economy. With regard to the borrower the lender will look to revenue and growth trends, as well as indicia of management skills. Have sales increased or decreased? Is there a recognizable trajectory in either direction? All businesses have ups and downs but multi-year trends can show a lender whether the ups and downs are aberrations or whether they are symptoms of strong or weak management. To the same purpose, lenders will compare certain financial ratios against industry benchmarks set by peer businesses. A favorable comparison indicates superior management ability.
With regard to the business’ industry or the economy as a whole, recall that banks consider their loans to be investments in their clients’ businesses. That said, an investment in an ailing industry is riskier and should either command a premium rate of return or be passed on altogether.
In conclusion, understanding how lenders make credit decisions is critical for business owners and their advisory team. There are both objective and subjective elements to the process, and too frequently lenders end up working almost exclusively from the objective elements and have to infer the subjective ones.
Your advisory team should help you obtain and understand the objective industry benchmarks published by RMA (Risk Management Association) and widely referenced in the banking world. Then, with the 5 Cs in mind, you can be proactive in helping your lender understand the subjective factors as they relate to your business. This approach provides business owners with their best tool for obtaining the credit that they need on the terms that they want.